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Thursday, August 02, 2007

Why the turbulence in global financial markets?

My starting point is Jim Hamilton's treatment of the July news in US housing. But how did the difficulties of loans inappropriately given to poor credits in the US turn into global financial market fluctuations? Matthew Goldstein and David Henry have written The pain moves beyond subprime in Business Week, which helps in understanding some of the linkages at work.

If you had any doubt about the spreading problems in the US economy, Jim Hamilton points out that the July automobile sales data - 14% down compared with last year and 17% down compared with July 2004 - were not just another bad sales month. One opinion poll shows that two-thirds of individuals in the US are decidedly gloomy about the economy.

The VIX rose from roughly 12 to roughly 24 over the last 3 months [link]: a dramatic increased in the ex-ante uncertainty about US equities.

The normalisation of the two global asset market anomalies of the period from 2003 to QI 2007 - very low long-term risk-free real interest rates and astonishingly low credit risk spreads across the board - is proceeding apace. Long-term risk-free real rates are no more than about 50 bps from their long-term historical average - certainly if we filter out the transitory flight to quality that has temporarily boosted government bond prices for the past few weeks. Default risk premia on corporate debt, and on the debt of any institution exposed to the US subprime mortgage market are almost back to normal. Credit spreads further removed from the subprime debacle are still low, including emerging market debt of countries that don't have foreign exchange reserves coming out of their ears (there are some!).

What is interesting is that global stock markets have gone through a non-trivial, albeit still modest, downward adjustment in the last couple of weeks, and especially at the end of last week. Such a correction is quite consistent with the often-heard view that, compared to debt and credit default risk , that is, given then prevailing long-term interest rates and credit risk spreads, equity was not overpriced during the asset anomaly period. All that statement means, after all, is that the price of equity seemed reasonable, in that it could be explained in terms of the three key fundamentals: projected future earnings, risk-free discount rates and a reasonable guess at the equity risk premium. There was no need to rationalise equity valuations as the result of a bubble in the stock market. However, even if there was no bubble in the stock market, equity could have been the beneficiary of a bubble in the bond markets, and even of the credit risk market anomaly, if the equity risk premium responded to the same force(s) that kept the default risk premium artificially low.

A fall in the stock market is, in fact, quite easily rationalised as a result of the fundamental shocks that caused weakening of the two asset market anomalies. Even if the anticipated future path of earnings were unchanged, the bursting of the bond market bubble that, in my view, caused almost of the increase in longer-term risk-free discount rates, would have a negative impact on equity values through an increase in the risk-free component of the equity earnings discount rate.

It is true that higher default risk premia caused by a sudden reduction in risk tolerance (an exogenous shift towards fear on the greed - fear spectrum) does not necessarily imply a higher equity risk premium. It is, however, not difficult to come up with quite plausible stories that would have credit risk premia and the equity risk premium going up in tandem; for instance, an increase in risk aversion, holding constant the covariance between consumption growth and the return on equity, would do the job. Finally, expected future earnings growth could have been revised downwards, either independently of the shocks causing the two asset market anomaly corrections or (partly) as a result of these same shocks. There is, however, no evidence, either aggregate or at the level of individual corporate earnings reports, of any unexpected weakness in corporate earnings.

Three key global asset market now have flashing amber lights. Does this mean we are about to see the end of the five golden years that saw global real GDP growth never far below 5 percent per annum? Possibly but not likely. The fourth (set of) key global asset price(s), exchange rates, are continuing to play a stabilising role. The US dollar is tanking, as it must. The yen is finally strengthening, as it ought to. The euro and sterling are strong as a DDR body builder on steroids (there is some redundancy in this simile), but there seems to be remarkably little pain.

While we may seem some weakening of real economic activity in the remainder of 2007 and in 2008 relative to what was expected earlier (pace the IMF which just revised its forecasts for 2007 and 2008 upward), I believe it more likely that we will continue to see a lot of Sturm und Drang in global financial markets, especially in the overdeveloped world, but rather little noticeable weakening of real economic activity. The financial superstructure appears increasingly to exist in a world of its own, cocooned off from the rest of the world. Fortunes are won and lost, but except for those immediately affected, it really does not impact much on anything real, that is, on anything that matters.

On the subject of this remarkable financial superstructure, you might like to see this blog entry.

A few months ago, the long-standing problems of “global imbalances” appeared to be abating, with a soft landing involving a dropping dollar and slow US GDP growth. Now, fears about global macro-economic worries are back on the front pages. Three major things have changed in recent weeks. The trouble in US housing has turned out to be much worse than was earlier felt to be the case. Many financial firms have failed—in the US and elsewhere. Credit spreads have risen sharply and risk perceptions have been revised upwards.

Stock prices fared very well in the last year, with the Nifty gaining 35 per cent and the S&P 500 gaining 12 per cent. Now fears about the world economy have led to lower stock prices. Home construction is the worst-performing industry in the US; shares of companies in the field have lost 60 per cent over the last two years. In addition, the projections embedded in option prices show an upsurge of volatility. The S&P 500’s implied volatility has surged to 25 per cent, the highest in three years. In India, so far, the implied volatility is at 27 per cent, which is modest for India’s markets. The relative numbers suggest that India’s markets have some ground to lose before they stabilise.

An opinion poll conducted by the Wall Street Journal shows that as many as 66 per cent of the respondents believe the US will now have a recession. This conveys the gloom in the US. Will the US Federal Reserve mount a rescue by swiftly cutting interest rates? It is unlikely. The Fed is a de facto inflation-targeting central bank. The expected inflation embedded in the prices of inflation-indexed bonds in the US is at 2.3 per cent, which is above the 2 per cent target. Until future inflation softens perceptibly, the US Fed is unlikely to cut rates. At present, the derivatives markets are showing a 20 per cent probability of a rate cut by the Fed by September and a 40 per cent probability of a rate cut by October. In India, all these financial markets are missing, and the central bank’s objectives are not clearly specified, hence it is not possible to anticipate what the RBI will do.

How would India be affected in an unhappy scenario? A recession in the US would lead to soft prices of tradeable goods worldwide, particularly given the massive investment boom in China focused on producing these tradeables. Hence, profits rates of Indian firms producing tradeables would be adversely affected. This would apply not just for companies exporting goods, but also for a company producing goods for the domestic market which are priced by import-parity pricing. The net profits of Indian companies have grown remarkably from 2002. The unhappy scenario would dent this profit growth. It would also diminish optimism, and thus investment demand.

A feature of recent weeks has been the robustness of global financial capitalism. A few hedge funds have gone bust, with losses of billions of dollars. A few very rich customers of the hedge funds have suffered big losses. Barring that, nobody seems to have got hurt. Hedge funds are, thus, shaping up as an important new shock absorber in global capitalism. In India, this shock absorber is lacking, through longstanding efforts by policymakers at preventing a hedge fund industry from coming about. The key tool for confronting future events, then, remains price flexibility. If there is bad news, the government should not prevent stock prices and the rupee from losing ground. These are the essential equilibriating responses of the system of financial markets.

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